Portfolio Strategy: Leveraging Low Margin Rates To Add Yield To Your Portfolio With Measured Risk

| About: iShares U.S. (PFF)

Summary

Many brokers are starting to offer extremely low margin rates, some even as low as 1%, which opens up new investment opportunities that are traditionally not available to retail investors.

The question lies in how to best utilize low margin rates to boost portfolio yield.

Investors could potentially boost their portfolio yield by an additional 1-2% annually with measured risk by implementing this strategy.

Leveraging the previously mentioned margin rates, purchasing a portfolio made up of municipal bonds, preferred stocks, REITs and other fixed income instruments may be a great way to produce income.

Investors should be aware of some potential weaknesses of this strategy as well, including tax treatments, the risks of high beta underlying portfolio and weakness in a rising rate environment.

Traditionally, margin has been thought of as a risky tool for investors to use. It is a double edged sword, as it can greatly magnify gains or losses. Traditionally, margin rates have been high enough that it has been unwise to use margin to purchase fixed income instruments, whose yield is often much lower than the margin rates that most brokers offer. Margin interest rates have started to come down, enough so that unique new investing opportunities are becoming available at some brokerage firms.

In this article, I'll lay out one possible way to boost portfolio yield by up to 2% using margin while adding measured risk.

Margin Interest Rates: Are They Low Enough to Work With?

I have traditionally agreed that margin is useless for purchasing fixed income instruments, but that changed when I came across margin rates that were lower than I expected. Some brokerage firms are now offering extremely low margin rates that make fixed income investing viable for some. If you take a look at the table below, you can see the margin rates for a $1M portfolio at leading online brokers. For those with multi-million dollar portfolios, you can expect the rates listed below for some brokers to decrease further.

Click to enlarge
(*Margin rates shown are the effective rates for a $1M portfolio, as shown at each respective broker's website)

The margin interest rates come down to a reasonable level only when a client has $1M or more, so this strategy may only be applicable to high net worth individuals at certain brokerages. Two notable examples from the chart above are the 6.5% margin interest rate at TD Ameritrade and the 1.35% margin interest rate from Interactive Brokers.

So as you can see above, some brokers offer low enough margin rates that make it possible to pursue unique opportunities that are traditionally not thought of as a good margin investment, such as purchasing fixed income instruments.

Portfolio Strategy: How to Best Utilize Low Margin Interest Rates

Now that we've established that the low margin rates offered by some brokerages create unique opportunities, the real problem is finding a way to efficiently utilize these margin rates.

I believe that one potential way would be for an investor to invest in a diversified portfolio as he normally would, but utilize a reasonable amount of his excess margin buying power to purchase a portfolio comprised of stable fixed income instruments.

My preferred pick for this role would be a portfolio of municipal bonds, which offer tax free income at a YTM that notably exceeds the margin rates offered by some brokerage firms. Municipal bonds are also less likely to suffer from the price fluctuations that exchange-traded products do, lessening the probability of a margin call.

What About Municipal Bond ETFs?

Another way that is perhaps simpler to implement (though in my opinion is a poor choice) would be to purchase a municipal bond ETF. One example is the PowerShares National AMT-Free Municipal Bond Portfolio ETF (NYSEARCA:PZA), which is composed of AMT free municipal bonds. After 0.28% in fund expenses, the net dividend yield is just over 3%. After subtracting margin interest (using IB's 1.35% rate as an example), you can get an additional 2% yield per year on your invested capital.

One downside of using ETFs for this purpose is that you may get a lower yield than if you constructed the municipal bond portfolio yourself. The beta on an ETF would be significantly greater than that of a portfolio made up of municipal bonds as well, increasing the chances for a margin call during hectic periods.

So while this option may be better for some, I recommend that investors who are considering this strategy to both conduct their own due diligence and to consider owning municipal bonds themselves as opposed to ETFs.

Utilizing Other Fixed Income Instruments in Conjunction with Municipal Bonds

Investors with a greater tolerance for risk have a wide variety of fixed income instruments that they can utilize for this strategy. For some investors, a blend of municipal bonds and higher yielding instruments may be the best choice.

A few instruments that I believe serve this purpose well, while remaining easy to implement, are Exchange-Traded Debt (ETD), corporate bonds and preferred stocks. REITs are another option for investors with a higher risk tolerance. The yield on any these instruments are often much higher than that of municipal bonds, though one should note that they are much riskier and are taxable. The beta will be much higher than a portfolio comprised of municipal bonds as well, so the risk of a margin call is not to be ignored.

DividendYieldHunter.com has aggregated a great list of ETD, REITs and preferred stock issues for investors to use as a point of reference when looking for investment ideas, though note that the yields on their spreadsheets are not entirely up to date.

Click here to view the ETD spreadsheet in Google Docs.

Click here to view the preferred stock spreadsheet in Google Docs.

Click here to view the REIT spreadsheet on DividendYieldHunter.com.

One popular preferred stock ETF that could potentially be a good way for investors to implement this strategy is the iShares U.S. Preferred Stock ETF (NYSEARCA:PFF). It yields about 5.3% after fund expenses, which offers a ~4% return on invested capital after accounting for margin expenses (using the example margin rates from earlier).

Tax Considerations

One important consideration when considering this investment strategy is taxes. Your tax bracket can be an important consideration when choosing between municipal and corporate bonds. Investors with high tax brackets will often find municipal bonds more attractive, while investors in lower tax brackets may find corporate bonds are a better fit.

Another tax consideration is whether or not a preferred stock pays qualified dividends. If a preferred stock pays qualified dividends, the distributions are usually taxed at just 15-20%. Note that ETD coupons are not eligible for the lower "qualified" tax rate like preferred stocks are.

Finally, one should know that the margin interest paid to your broker for this strategy would not be tax deductible. This means that the effective rate stated on their website is what you will actually be paying, with no tax incentives available to effectively lower it further.

Sample Portfolio

I have constructed a simple sample portfolio below to demonstrate what implementing this strategy might look like. It is purely an example and not in any way meant to be used as a template, as I believe that simply holding municipal bonds themselves is the best way to implement this strategy as it eliminates fund expenses and reduces the probability of margin calls.

Click to enlarge

Weaknesses

A few potential issues with this strategy may arise.

As I stated originally, the use of exchange-traded instruments instead of municipal bonds greatly increases the volatility and therefore the chance that a margin call may occur. To combat this issue, I recommend leaving a moderate buffer and not fully utilizing all of your margin buying power.

The volatility of each investor's underlying portfolio, which the margin buying power of the account is derived from, can also negatively affect this strategy. If an investor has a high beta portfolio, this strategy may not be the best choice, as the investor will be unable to invest most of their margin buying power since the required buffer would be much higher. So due to this, this strategy is best implemented in low beta portfolios.

If interest rates were to go up during the holding period of the municipal bonds, the value of the bonds would decrease and could potentially cause a margin call. This is another reason why those who choose to implement this strategy should utilize a buffer as described earlier.

Additionally, the tax treatments of different investments combined with the tax bracket of the investor implementing the strategy may restrict the profitability of this strategy.

Conclusions

To conclude, this is a very flexible strategy that can be as conservative or aggressive as the investor implementing it, as the risk and return primarily depend on the allocation chosen. For investors who construct a portfolio comprised purely of municipal bonds, it will be a lower risk and lower reward investment relative to an investor who builds a portfolio of REITs and preferred stocks.

As covered earlier in the article, this strategy would work best with low beta underlying portfolios owned by high net worth individuals who believe interest rates will not be rising any time soon and that no recession is within sight (I realize that this is an extremely specific demographic).

The tax implications are not to be ignored either and should be discussed with a tax professional or your financial advisor. The volatility of each investor's portfolio is also an important consideration when deciding whether or not this strategy is appropriate. This article is neither meant to be comprehensive nor a professional recommendation. I am purely laying out one potential strategy to boost yield. Investors should conduct their own due diligence before pursuing any investment strategy.

If you have any suggestions on how to best utilize low margin rates, implement this strategy or ideas on what fixed income instruments you would utilize, leave a comment below!

--

If you enjoyed this article and want to read more like it, please scroll to the top of the page and click the follow button next to my author profile. This will provide you with updates when actionable articles such as this are posted.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.